From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
For this week’s blog post, I was planning on doing a review of the latest Market Report that ISLA has been producing on a semi-annual basis for the past six years.
Then the market turmoil hit. As the saying goes, markets rise like an escalator and drop like an elevator and the Bloomberg chart is a vivid illustration of that. What a week. The chart shows $8 trillion was wiped off world stock markets capitalisation and in another memorable moment, US 10-year treasury yields hit an all-time low of 1.15%.
I considered changing the topic and then realised it is likely you are already being bombarded with stories about the market and there isn’t a lot I can add. However, I did hear a great quote from Chris Nagi of Bloomberg in an episode of ’What Goes Up‘ – describing the past 4-5 months’ stock market rise as an “orgy of bullishness”. I love that description. If you look at the chart, despite the precipitous drop, the market as at the end of February was only down to the levels experienced in Q4 2019. It may yet fall further, but we have been in a relentless upward trend for many years now and we all know that the real world has ups and downs.
Just a quick caveat here, the trends that have driven securities lending to this point may be broken by recent market ructions. Two important unknowns will set the tone for the coming months: are stocks now at more reasonable levels, presenting buying opportunities or will the price drops trigger a re-evaluation of the economic fundamentals; and how will Coronavirus impact the global economy? Of course, the run-up to the US election later this year will also influence investors and traders. It is impossible to predict how the markets will react and as securities lending volumes are a reactive secondary market activity, it is equally challenging to come to a single direction of travel for the business overall.
ISLA Market Report
I was part of the ISLA Board when the idea of a regular publicly available report was first raised. Since its launch, it has provided valuable insights not just for market participants but far more importantly, to the wider community of observers and stakeholders. The report gets better each time and the ISLA team and contributors do a great job with it. With so much information that gets produced every day across media, you can get lost – the ISLA report is one of only a handful of items that I consider to be truly a must-read. I’m sure you will agree the weekly Pierpoint blogs should be included in that list (or at least I hope you do).
Although equity lending was up marginally over the previous year, most commentators agree that revenues were down from 2018, an exceptional year. The report makes clear that while availability figures shot up dramatically, much of that tracked to the overall market price inflation. Revenues were driven by North American equities with IPOs, a few exchange offers and cannabis stocks being the primary fee sources. After a good start to 2020, the year’s equity lending revenues will be entirely driven by the market’s reactions to the events described above.
Both internalisation within prime brokers and synthetic transactions mask the total size of market for short exposures and total income generated by short sellers and paid to long investors. Given announcements from prominent firms on the contribution to their revenues, it seems safe to assume that a large proportion of lending has been replaced by these more bank resource-efficient alternatives
We again urge investors that can transact on a synthetic basis to consider this as a way of protecting and growing income. The recent addition of Jeroen Bakker to the Pierpoint team further enhances our depth of knowledge in this area.
There has been a general overall increase in the amount of government bonds on loan, with HQLA activity the impetus for growth alongside the spike in US treasuries last September and follow-on impact. Given that Uncleared Margin Rules regulation will capture a wider universe of investors this year and next, it seems inevitable that government bond balances will continue to rise. Despite the expectation that government bond lending will grow, it should be noted that borrowers have been improving their ways of sourcing HQLA liquidity so while demand growth will fuel increased balances, I suspect rates will remain in the same range as today.
UMR is already causing some realignment of prime brokers and we expect this to continue and accelerate as hedge funds rethink strategies, markets and synthetic vs cash provider selection.
It will also be interesting to see the impact of EquiLend’s new Collateral Trading product in this area.
The report mentions the relatively low acceptance of corporate bonds collateral – 10% of European securities lending collateral is held in European tri-party. Followers will know that I am not so keen on corporate bonds as collateral for lenders. I am making no comment on corporate bonds as investments as that is outside my area of expertise but let me share my views on using them as collateral. For me, the test for the effectiveness of collateral is dependent on circumstances that are likely to occur in the wake of a major counterparty default such as Lehman Brothers and needs to answer two questions – can I sell the asset and what is the price impact of selling.
Government bonds are considered as readily exchangeable for cash, even if that means accessing the relevant central bank. In the immediate aftermath of the Lehman Brothers default, US treasuries were relatively illiquid, but not because there weren’t any buyers, rather it was a shortage of sellers. If you wanted to sell, you could without issue, and given the buying demand, there was no price impact and in fact, the prices may have risen.
Equities typically would be expected to sell off, and we have seen many examples over the years of this. A collateral holder can sell large-cap equities even in difficult markets, otherwise, you wouldn’t see large volumes, but you would have to expect consequential price drops. So, you can sell, but at a cost, often described as fire-sale prices. However, as lenders are likely using the cash proceeds to repurchase equities, there is a degree of correlation between the valuations of collateral and replacement assets.
Corporate bonds, on the other hand, begin with relative illiquidity in normal markets and in my view, these conditions have been exacerbated by both new banking regulations over the past decade and the increased corporate issuance over the low-interest-rate environment. The liquidity starting point is weak and deteriorates in adverse conditions. That impacts both the ability to sell and the price that can be obtained in the event of a default. It may be that asset managers that run their own securities lending programmes may have an advantage here. In some firms, it may be that they would be willing to absorb corporate bond collateral as part of their investment portfolios rather than sell them and fund the repurchases from other sources. That would be the exception rather than the norm, so I remain of the view that corporate bond collateral should be limited if accepted at all.
According to a recent Barclays article ’2020 a new decade for hedge funds‘ the largest increase in allocations to hedge fund strategies has gone to Equity Long/Short funds, rising by 25% to $836 billion. That is potentially positive for securities lending, yet given the recent drops, there is perhaps a better case for applying money to the long side of the equation than was the case a few weeks ago. Barclays points to the expectation of increased hedge fund allocations for all investor types as shown in the chart.
I’d love to be able to paint a confident, positive outlook for the coming months, but that’s hard to do at the moment. Instead, I remind readers that securities lending makes a positive contribution to performance year after year, compounding the value it provides to investors. Further, investors should reassess whether their programme reflects a best-of-breed offering appropriate for their risk appetite. Additionally, those that are willing to consider new markets, trade types, collateral arrangements, synthetic alternatives and other adaptations can not only protect but grow their revenues without necessarily increasing their risk profile.